The job creation illusion

fedgazette Editorial

The spending of other people's money is always open to abuse. That
is why what government does with taxpayers' money is best guided
by good economic principles. One such principle is that governments
should invest in goods that taxpayers want but the market will not
provide. Falling under the general heading of infrastructure, these
investments include education and research, roads and bridges, water
and sewage systems, and public health and safety. According to economic
theory, if the government did not intervene in the market, these
goods would be produced in quantities far smaller than their value
to society. And that value is considerable: Research shows that
government's investment in infrastructure has consistently bolstered
long-term economic growth.

In recent years, something other than this economic principle
has been guiding state and local government investments--the idea
that government should invest in private businesses that create
jobs. These investments often take the form of low-interest government
loans to new or expanding businesses, and the option of investing
in job creation this way is seductive. Unlike investing in infrastructure,
investing in job creation appears to have small costs and highly
visible returns that accrue in a relatively short period of time.
A closer examination, however, reveals that in fact the costs can
be great and the returns are illusions. Therefore, constraints on
these investments need to be strengthened.

State and local governments finance private businesses with tax-exempt
bonds known as industrial development bonds (IDBs). The bonds are
converted into low-interest private business loans by using the
proceeds to buy or build some desired capital (an office building
or a factory, for example) and leasing the capital to the business.
The rental income generated by the lease agreement is used to service
the debt, and the capital secures the loan.

Both parties appear to benefit from these transactions. Of course,
the private business that receives the government loan is better
off because it is able to finance a significant part of its capital
at a rate much lower than it could get on its own. The local economy
is presumably better off because it now has more jobs. Its out-of-pocket
expenses are negligible, and its revenue loss is small. Furthermore,
if the business is successful, the local government could eventually
end up with more revenue than it would have otherwise.

As the numbers show, state and local governments have taken advantage
of this form of financial aid to their economies. In a recent 10-year
period, close to $400 billion worth of private-activity IDBs were
issued, $99 billion alone in 1985. The big numbers, however, have
not translated into big benefits because the returns on such loans
are nothing more than illusions.

To see what I mean, consider the following example. A hypothetical
firm has decided to borrow $10 million at the market rate--say,
at 17 percent--in order to expand its local operations and create
100 new jobs. Learning of the firm's plans, some outside community
offers a low-interest loan to the firm--say, at 14 percent--because
it can issue federally tax- exempt IDBs. The local community, concerned
about losing these new jobs, counters with the same offer. The firm
decides to expand as originally planned and saves three percentage
points on its capital expenses.

Has the local government created any new jobs? Probably not. From
the local view, one might argue that the loan brought new jobs to
the community. If the counteroffer had not been made, the jobs would
have gone elsewhere. But clearly, from a national view, jobs were
neither lost nor created; the financial aid just helped to determine
where the new jobs would be located.

What about the possibility that the firm might not have expanded
its operations without government assistance? If that is true, then
the government has created 100 jobs. But governments shouldn't be
creating jobs this way. They have no inherent advantage over private
credit markets in predicting which firms will succeed and which
will fail. The Eastern Europeans, for example, have demonstrated
how costly it can be to let governments determine which firms receive
financial support, rather than leave these decisions to private
markets.

Congress has been well aware of this fruitless competition among
state and local governments for new jobs. Since the late 1960s,
Congress has been trying to control the growth of tax-exempt bonds
that are issued to finance private activities. In 1986, it strengthened
its controls by imposing volume caps on these types of IDBs. Today
a state and its local governments can issue each year only $150
million worth of private-activity, tax-exempt IDBs, or $50 per capita,
whichever is greater.

State and local governments, however, have found a loophole that
they are beginning to use aggressively. Some are now offering federally
tax- exempt general obligation IDBs as a way to get around the caps.
These IDBs are backed by the full faith and credit of the issuing
government, rather than being revenue bonds (bonds secured by the
revenue of the business receiving the loan). And there are no federal
limits on the amount of general obligation bonds that state and
local governments can issue.

In some ways, the option of issuing general obligation bonds to
create jobs is even more seductive than issuing revenue bonds. Not
only are general obligation bonds tax exempt, they also have a very
low risk of default because the issuing state or local government
guarantees the debt service. The bonds, therefore, sell well below
market rates, and private businesses get an even lower-rate loan
than those financed by revenue bonds. Again, both parties appear
to gain, and only the federal government loses.

But there is an illusion here too, this time covering up the cost
to the local taxpayers. Local taxpayers, rather than the bondholders,
now bear the risk of business failure. Remember our hypothetical
firm that would have had to pay 17 percent to borrow in the market
but managed to save three percentage points by borrowing from a
community issuing tax-exempt revenue bonds? Suppose it instead were
to receive the proceeds from the issue of general obligation bonds,
for which the local government would probably have to pay only a
7 percent rate (roughly the going rate on such bonds today). Our
hypothetical firm would now save 10 percentage points, 3 percentage
points because the bonds are tax exempt and 7 percentage points
because the bonds are secured by the full faith and credit of the
issuing government. The 7 percentage points represent the cost of
the credit risk which is borne by the local taxpayers. The implicit
annual subsidy to the firm, therefore, is 7 percent of our original
$10 million, which is $700,000, or $7,000 per job. If such costs
were made explicit, I suspect taxpayers would have doubts about
such an investment, especially those taxpayers who never received
such assistance when they expanded or started their businesses.

As we have seen, Congress already had such doubts. In 1986, convinced
that allowing state and local governments to compete for jobs with
IDBs was a mistake, it acted to severely limit such competition.
But Congress succeeded in limiting only one type of competition.
Over the last five years, state and local governments have found
a new and costlier way to compete for jobs--tax-exempt general obligation
bonds. Congress needs to close this loophole by eliminating the
tax-exempt status on all bonds issued for private activities.

As for state and local governments that may still want to issue
taxable general obligation bonds to promote job creation, they should
be required to make local taxpayers aware of the hidden costs. Once
taxpayers are fully informed, state and local governments will likely
return to competing for business by offering more and better types
of infrastructure. At least the return on these investments will
be no illusion.